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Concept of Multiplier (with a Numerical Problem)

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Multiplier is one of the most important concepts developed by J.M. Keynes to explain the determination of income and employment in an economy. The theory of multiplier has been used to explain the cumulative upward and downward swings of the trade cycles that occur in a free-enterprise capitalist economy.

When investment in an economy rises, it has a multiple and cumulative effect on national income, output and employment. As a result, economy expe­riences rapid upward movement. On the other hand, when due to some reasons, especially due to the adverse change in the expectations of the business class, investment falls, then backward working of the multiplier causes a multiple and cumulative fall in income, output and employ­ment and as a result the economy rapidly moves on downswing of the trade cycle. Thus, Keynes­ian theory of multiplier helps a good deal in explaining the movements of trade cycles or fluctuations in the economy.

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The theory of multiplier has also a great practical importance in the field of fiscal policy to be pursued by the Government to get out of the depression and achieve the state of full employment. To get rid of depression and remove unemployment, Government investment in public works was recommended even before Keynes.

But it was thought that the increase in income will be limited to the amount of investment undertaken in these public works. But the importance of public works is enhanced when it is realised that the total effect on income, output and employment as a result of some initial investment has a multiplier effect. Thus, Keynes recommended Government investment in public works to solve the problem of depres­sion and unemployment.

The public investment in public works such as road building, construc­tion of hospitals, schools, irrigation facilities will raise aggregate demand by a multiple amount. The multiple increases in income and demand will also encourage the increase in private invest­ment.

Thus, the deficiency in private investment which leads to the state of depression and underemployment equilibrium will now be made up and a state of full employment will be restored. If the multiplier had not worked, the income and demand would have risen as a result of some public investment but not as much as they rise with the multiplier effect. Inspired by the Keynesian theory of multiplier.

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Expansionary fiscal policy of increase in Government ex­penditure and reduction in income tax was have been adopted by President John Kenedy and press president George W. Bush in the United State of America to remove involuntary unem­ployment and depreciation. This had a great success in removing unemployment and, depression and therefore, Keynesian theory of multiplier was vindicated and as a result people’s belief in it increased.

A Numerical Problem on Multiplier:

Problem:

Suppose the level of autonomous investment in an economy is Rs. 200 crores and consumption function of the economy is:

C = 80 + 0.75Y

(a) What will be the equilibrium level of income?

(b) What will be the increase in national income if investment increases by Rs. 25 crores.

Solution, (a) For equilibrium level of income,

Y = C + I

Where C = 80 + 0.75

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I = 200 crores

Substituting the values of C and I in (1) we have

Y = 80 + 0.75Y + 200

(Y – 0.75F) = 80 + 200 = 280

0.25 Y = 280

Y = 280 x 100/25 = 1120

Equilibrium level of income is therefore equal to 1120 crores.

b) How much increase in income will occur as a result of increase in investment by Rs. 25? The size of multiple is determined by the value of marginal prepensely to consume. In the given consumption function (C = 80 + 0.75 Y) marginal propensity to consume is equal to 0.75 or 3/4 Thus, multiplier = 1/1-MPC = 1/1-3/4 = 4

Thus, with increase in investment by Rs. 25 crores, national income will rise by 25 x 4 = 100 crores.